Enron's fall foreshadowed 2008 crash

By TOM FOWLER, HOUSTON CHRONICLE |
December 1, 2011

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The collapse of Enron was a closely watched and thoroughly documented corporate event, a slow-motion cataclysm chronicled in thousands of articles, dozens of case studies, movies and even a play.

Despite that coverage, corporate America and lawmakers have missed or ignored a number of key lessons, in the view of several people who know the case well.

Exhibit No. 1 on the lessons unlearned: the 2008 financial collapse.

"It had the same ingredients as Enron's demise, namely excessive leveraging, funding long term commitments with short term borrowing, and a lack of transparency," said Vince Kaminski, the former managing director of research at Enron. "If we had learned better the lessons of Enron we might not have had the current financial crisis."

Sam Buell, one of the first prosecutors on the federal government's Enron Task Force and now a law professor at Duke University, says he's been "dumbfounded" by the extent to which Enron's lessons have been lost.

"We thought Enron was the 9/11 of the financial markets, that it was a cataclysm that would change the world," Buell said. "The financial collapse of 2008 is evidence that it didn't. Enron was the canary in a coal mine warning about the systemic problems that we needed to look at, particularly where it comes to risk management."

Enron's collapse came fast and furious in the fall of 2001 - culminating in its bankruptcy on Dec. 2 - 10 years ago Friday.

The company was showing some signs of distress early in the year, with layoffs in some divisions in the spring and efforts to conserve cash started in the summer. But momentum picked up when the company reported a surprising loss during its third-quarter earnings call on Oct. 16.

Fastow's partnerships

About the same time, investment partnerships created by Chief Financial Officer Andrew Fastow began drawing attention.

The LJM partnerships - which had the approval of Enron's board - were formed using Enron equity and outside capital as a way to hedge against the risks involved in some of the company's new lines of business and investments.

Fastow's dual roles as a company executive and managing director of the LJMs prompted a Securities and Exchange Commission investigation as well as an internal Enron investigation that led the company to cut its officially reported earnings over the previous 4½ years by nearly $600 million.

Those problems shook investor and trading partner confidence in Enron, leading to a sharp drop in its stock price and cuts in its credit rating. The falling stock price triggered defaults in some of the off-books partnerships, which deepened the financial problems.

A takeover attempt by rival Dynegy Corp. fell apart in late November when that company realized the depth of Enron's financial woes. With no White Knight and lenders unwilling to help the company further, Enron filed for bankruptcy.

Just as the LJM partnerships were an effort to move risky assets off Enron's balance sheet, financial institutions a few years later thought they were removing the risks of shaky home mortgages through similar off-books partnerships, Kaminski said.

"The idea was that if they were out of sight, they weren't a threat," Kaminski said. "But they were highly misleading, not just to outside investors but to the management of the financial firms, too."

The new financial rules that followed Enron's downfall, the Sarbanes-Oxley Act, increased the penalties for wrongdoing and put greater emphasis on the role of auditors, but didn't create a broader system of controls to monitor and prevent overly risky decisions, Kaminski said.

The new legislation introduced following the 2008 financial crisis, the Dodd-Frank Act, tries to address the systemic risk issue by requiring greater transparency of exotic financial instruments and advanced warning systems that watch for risks. But Congress already is working to undermine some provisions of Dodd-Frank, while companies are studying ways around its rules.

Sees a cycle

The reaction to major events like the collapse of Enron and the 2008 meltdown is usually a legislative over-reaction, which is then followed by overly strong counter-reaction, said Leslie Caldwell, the first director of the Enron Task Force who is now a partner with the law firm Morgan Lewis.

Changes in internal corporate behavior - with priorities set at the top of the organization - will go a lot further than onerous legislation, Caldwell said.

"People are motivated by what they think they're rewarded for," she said.

Cindy Olson, a former human resources manager at Enron, agreed that its demise demonstrated the need for proper systems of motivation and reward.

In the late 1990s Enron followed the trend of many companies by making options a larger part of executive pay, including options with relatively short vesting periods.

"I don't believe anyone had fraudulent intent, but no one realized the kinds of risks people were motivated to take to keep our stock price going up," Olson said. "It made them wealthy, but it maybe didn't support the best long-term decisions."